Dealing with Crummey powersArticle added by Julius Giarmarco on October 7, 2013
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The increased estate tax exemption ($5.25 million for a single person and $10.5 million for a married couple, indexed for inflation), courtesy of the American Taxpayer Relief Act of 2012 (ATRA), results in fewer persons having taxable estates.
But, for those persons with taxable estates, the irrevocable life insurance trust (ILIT) remains one of the most (if not the most) tax efficient vehicles to leverage gifts and provide liquidity to pay estate taxes. No part of an ILIT creates more issues and controversy than the need to use annual withdrawal powers in order to qualify gifts to the ILIT for the $14,000/$28,000 annual gift tax exclusion. These powers are sometimes called Crummey powers (named after the court case that validated the technique).
This article will discuss several strategies to simplify the Crummey withdrawal power process.
Types of notice
Unless the beneficiaries of the ILIT are given notice of their withdrawal rights, gifts to the ILIT will not be eligible for the annual gift tax exclusion. Written notice to the beneficiaries of their withdrawal rights is the best evidence of notice. However, trustees often forget or neglect to send the beneficiaries written notice. Accordingly, the ILIT should also permit other forms of notice, so that if written notice is not given, the IRS cannot automatically treat all gifts made to the ILIT as taxable gifts.
In Private Letter Ruling 199912016, the IRS determined that a father’s contributions to two trusts qualified for the gift tax annual
exclusion where the beneficiary had “reasonable notice” of the contributions. Unfortunately, the PLR did not specify what “reasonable notice” consists of.
The ILIT should allow for any form of notice, including written, verbal, constructive, or “one-time” notice, or even no notice, when the beneficiary has actual notice. In Estate of Holland v Commissioner, TC Memo 1997-302; and PLRs 8008040 and 9030005, no other notice was required where the beneficiary had actual notice of gifts made to the trust (i.e., the beneficiary was a trustee, or a minor beneficiary's legal guardian was a trustee).
In addition, in four Private Letter Rulings from 1981 (PLRs 8143045, 8133070, 8138102 and 8121069), the IRS recognized a one-time notice that identified when future contributions were expected to be made. A one-time notice is particularly useful for ILITs funded with group-term policies.
In PLR 9532001, the IRS ruled that it would recognize Crummey withdrawal powers only in those situations in which the beneficiaries receive actual “current” notice of any gifts made to the trust. Thus, current written notice should be the goal, but
other types of notice should not be omitted from the ILIT.
Paying premiums during the withdrawal period
The lapse of a Crummey power is a release of a general power of appointment to the extent the lapse exceeds the greater of $5,000 or 5 percent of the trust principal during the calendar year. By limiting a beneficiary’s annual withdrawal power to
the greater of these amounts, or by using so- called “hanging powers” within those same limits, the beneficiary will not be treated as making a “gift back” to the ILIT of the excess amount.
Gift-back treatment is to be avoided because the amount in question will not be a present interest gift and, therefore, will result in the beneficiary having to file a gift tax return (IRS Form 709) and using up an equivalent portion of his or her $5.25 million gift tax exemption.
In addition, the gift back will cause the beneficiary to be a transferor of the ILIT for generation-skipping tax purposes, thereby possibly wasting a portion of any GST allocation made by the grantor to the ILIT.
The $5,000 or 5 percent exception refers only to a “lapse” of a power, not to a “release” or “waiver” of a power.
Therefore, a Crummey power should never be released or waived. Does this mean that the trustee has to wait until the withdrawal period ends before paying the premium? If so, this could present problems for the initial premium where the trustee does not want to wait for the withdrawal period to expire before putting the policy in force.
It can also be a problem when a premium is past due and the remaining grace period is shorter than the withdrawal period specified in the ILIT. Although there is no authority on this point, it should be possible to provide in both the ILIT and the notice letter that the trustee is permitted to use gifts to pay premiums during the withdrawal period. As long as the Crummey withdrawal power is lapsing (as opposed to being released), the $5,000 or 5 percent exception should be available. For the Crummey withdrawal powers to be legitimate, the ILIT should allow the trustee to access cash values and to transfer a fractional interest in the policy itself to satisfy any exercised withdrawal powers.
Ability to change Crummey power holders
The ILIT should give the grantor (or any other donor) the right to cancel or modify a beneficiary’s (or contingent beneficiary’s) annual withdrawal rights for two reasons. First, a beneficiary may become uncooperative and begin exercising his or her withdrawal rights, thereby thwarting the purpose of the ILIT. Second, if the grantor has a sufficient number of beneficiaries to cover the gifts being made to the ILIT, the grantor may wish to cancel a particular beneficiary’s withdrawal right to make different annual exclusion gifts to that beneficiary.
In Private Letter Ruling 9834004, the IRS approved an ILIT provision that gave the grantor the ability to cancel a beneficiary’s withdrawal right, modify the amount subject to withdrawal, and change the period during which the beneficiary’s withdrawal power could be exercised. The IRS ruled that such a provision would not cause any adverse gift or estate tax consequences.
One advantage of ATRA is that for persons with ILITs who no longer have taxable estates, they may be able to do away with sending out Crummey notices. But, see Don’t throw away those old ILITs just yet for a number of reasons why those same persons should retain their ILITs.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.
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